CHAPTER SEVENTEEN ACCOUNTING FOR ACCOUNTS RECEIVABLE

SALES ON ACCOUNT  Offering customers the ability to pay “on account” oINCREASES SALES  But, some customers do not pay oThis is considered an expense oTwo methods of accounting for this expense: Allowance method Direct write-off method

ALLOWANCE METHOD  A method that recognizes bad debts expense in the same period that the related credit sales are made oconsistent with the Matching Principle  Three step process oStep #1-Estimate amount of uncollectible accounts. oStep #2-Adjusting entry is made. oStep #3-Subsequently, uncollectible accounts are identified and written off.

STEP #1 ESTIMATING UNCOLLECTIBLE ACCOUNTS  Two methods: oPercentage of Sales Method Based on the relationship between the amount of credit sales and the amount of uncollectible accounts oPercentage of Receivables Method Based on the relationship between the amount of accounts receivable and the amount of uncollectible accounts

PERCENTAGE OF SALES METHOD Step #1 Determine the % of credit sales expected to become uncollectible. This can be done by looking at the company’s prior credit experience, industry averages or percentages for similar companies.

PERCENTAGE OF SALES METHOD EXAMPLE: Chris Co. had total credit sales of $200,000, and $2,000 of those credit sales had become uncollectible. Uncollectible Accounts Credit Sales $2,000 $200,000 1% This is used in future periods to estimate uncollectible accounts.

PERCENTAGE OF SALES METHOD EXAMPLE: During the next year, Chris Co. has credit sales of $120,000. What amount should be recorded as “Bad Debts Expense” for this year? Credit Sales X Est. % Uncollectible Estimated Uncollectible Accounts $120,000 X 1% $1,200

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Adjusting Entries Dec Bad Debts Expense Allowance for Bad Debts 1,200 The Income Statement will show… Revenues (Sales) of $120,000 and Bad Debts Expense of $1,200.

PERCENTAGE OF SALES METHOD Subsequent write-offs Let’s look at how write-offs are recorded under the allowance method.

PERCENTAGE OF SALES METHOD Subsequent write-offs Under the allowance method, write-offs affect the Balance Sheet only!

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Allowance for Bad Debts Accts Rec./Cust. Names 1,100 The Allowance account, Accounts Receivable account and subsidiary ledger account are all reduced.

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Allowance for Bad Debts Accts Rec./Cust. Names 1,100 The Bad Debts Expense account is not affected. The expense of this uncollectible account was recognized in the adjusting entry in the period of the related sale.

PERCENTAGE OF RECEIVABLES METHOD Simplest form: Applying an estimated percentage of uncollectible accounts to the Accounts Receivable balance, to determine “Estimated Uncollectible Accounts”

PERCENTAGE OF RECEIVABLES METHOD EXAMPLE: Craft Co. had an average Accounts Receivable balance at the end of the past two years of $110,000, and average uncollectible accounts of $4,400. Avg. Uncollectible Accts Average Accounts Receivable $4,400 $110,000 4% This is used in future periods to estimate uncollectible accounts.

PERCENTAGE OF RECEIVABLES METHOD EXAMPLE: At the end of the current year the Accounts Receivable balance was $120,000. What amount should be recorded as “Bad Debts Expense” for this year? Accts Receiv. X Est. % Uncollectible Estimated Uncollectible Accounts $120,000 X 4% $4,800

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Adjusting Entries Dec Bad Debts Expense Allowance for Bad Debts 4,800 Assuming the Allowance account has a zero balance prior to this adjustment

AGING THE RECEIVABLES  Aging schedule is prepared which details: oEach customer’s account balance categorized by how long it has been outstanding oEstimated percentage uncollectible based on the “age” of the account  This computes a more precise estimate of uncollectible accounts.

AGING SCHEDULE OF ACCOUNTS RECEIVABLE Dec 31, 20-1 Customer W. Billiard $ 3,000 TotalNot Yet Due $ 2,500 K. Campbell 950 J. Farley 4,325 3,800 L. Gilbert 1,900 1,500 E. Rome 3,950 3,170 B. Zimmerman 200 Customers and balances are listed.

AGING SCHEDULE OF ACCOUNTS RECEIVABLE Dec 31, 20-1 Number of Days Past Due Over 365 $ 500 $ 650 $ 300 $ $ The balances are separated and classified by how long they have been outstanding.

AGING SCHEDULE OF ACCOUNTS RECEIVABLE Dec 31, 20-1 Customer W. Billiard $ 3,000 TotalNot Yet Due $ 2,500 K. Campbell 950 J. Farley 4,325 3,800 L. Gilbert 1,900 1,500 E. Rome 3,950 3,170 B. Zimmerman 200 Total $100,500 $65,000 Each category is totaled.

AGING SCHEDULE OF ACCOUNTS RECEIVABLE Dec 31, 20-1 Customer W. Billiard $ 3,000 TotalNot Yet Due $ 2,500 K. Campbell 950 J. Farley 4,325 3,800 L. Gilbert 1,900 1,500 E. Rome 3,950 3,170 B. Zimmerman 200 Total $100,500 $65,000 Estimated percent uncollectibles 2% Percentages, based on past experience are applied to each category. Total Est. Uncollectible Accounts $1,300

AGING SCHEDULE OF ACCOUNTS RECEIVABLE Dec 31, 20-1 Number of Days Past Due Over 365 $ 500 $ 650 $ 300 $ $ $18,000 $8,250 $6,310 $1,810 $ 780 $ 350 5% 10%20%30%50%80% The percentage increases as the accounts become older and less likely to be collected. $280 $900 $825 $1,262 $543 $390

AGING SCHEDULE OF ACCOUNTS RECEIVABLE Dec 31, 20-1 Customer W. Billiard $ 3,000 TotalNot Yet Due $ 2,500 K. Campbell 950 J. Farley 4,325 3,800 L. Gilbert 1,900 1,500 E. Rome 3,950 3,170 B. Zimmerman 200 Total $100,500 $65,000 Estimated percent uncollectibles 2% Total estimated uncollectible accounts $ 5,500 $ 1,300 All the categories’ estimated uncollectible accounts are totaled.

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Adjusting Entries Dec Bad Debts Expense Allowance for Bad Debts 5,500 Assuming the Allowance account has a zero balance prior to this adjustment

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Allowance for Bad Debts Accts Rec./Cust. Names 5,200 During the year, accounts totaling $5,200 are written off.

AGING THE RECEIVABLES Allowance for Bad Debts $5,500 12/31/x1 Adj. $5,200 Write-offs during 20x2 $ /31/x2 Bal. After write-offs, the allowance account is left with a $300 credit balance.

AGING THE RECEIVABLES EXAMPLE: At the end of 20x2, another aging schedule is prepared and it shows estimated uncollectible accounts of $5,700. The $5,700 is the balance needed in the Allowance account.

AGING THE RECEIVABLES Allowance for Bad Debts $5,500 12/31/x1 Adj. $5,200 Write-offs during 20x2 $ /31/x2 Bal. $5,700 Need a balance of $5,700 but balance is only $300 Desired 12/31/x2 Bal.

AGING THE RECEIVABLES Allowance for Bad Debts $5,500 12/31/x1 Adj. $5,200 Write-offs during 20x2 $ /31/x2 Bal. $5,700 An adjustment of $5,400 is needed. $ 5,400 Adj. Desired 12/31/x2 Bal.

COMPARISON OF ALLOWANCE METHODS FEATUREPERCENTAGE OF SALES PERCENTAGE OF RECEIVABLES Basis for estimate % of credit salesAging (%) of accounts receivable Amount of year- end adjustment Amount calculated above Amount calculated above Plus debit balance in allowance account before adjustment or Minus credit balance in allowance account before adjustment

COMPARISON OF ALLOWANCE METHODS FEATUREPERCENTAGE OF SALES PERCENTAGE OF RECEIVABLES Balance after adjustment Amount calculated above Plus debit balance in allowance account before adjustment or Minus credit balance in allowance account before adjustment Amount calculated above

EFFECT OF WRITE-OFFS  ON THE INCOME STATEMENT  No effect  The expense was already recognized during adjusting entry  ON THE BALANCE SHEET oNo effect oWrite off decreases both the asset (Accounts Receivable) and the contra asset (Allowance for Bad Debts)

RECOVERY OF A PREVIOUSLY WRITTEN OFF ACCOUNT EXAMPLE: A check for $500 was received on February 1 from Bill McDonald, whose account was written off on January 15. This requires two entries!

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Accts. Rec./B. McDonald Allowance for Bad Debts 500 Step #1 Reinstate the account (reverse the write-off). Feb.1 Reinstated acct receiv.

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Accts. Rec./B. McDonald Allowance for Bad Debts 500 Step #2 Record the collection. Feb.1 1 Cash 500 Accounts Receivable Reinstated acct receiv. Collection on account 500

DIRECT WRITE-OFF METHOD  Bad Debt Expense is not recognized until it has been determined that an account is uncollectible.  Advantage: It’s simple.  Disadvantages: oViolates the matching principle oAmount of expense can be manipulated oBalance sheet does not reflect amount of Accts. Receivable actually expected to be received

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 J. Lafollete’s account is written-off under the direct write-off method. Aug.15

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 If he subsequently pays the $500 IN THE SAME ACCOUNTING PERIOD, two entries are needed. Aug.15

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 Step #1 Reinstate the account (Reverse the write-off). Aug. 15 Dec.20 Accts. Rec./J. Lafollette Bad Debts Expense 500

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 Step #2 Record the collection. Aug. 15 Dec.20 Accts. Rec./J. Lafollette Bad Debts Expense Accts. Rec./J. Lafollette Cash 500

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 Now let’s see how the entries would be different if he subsequently pays the $500, IN A DIFFERENT ACCOUNTING PERIOD. Aug.15

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 Step #1 Reinstate the account crediting a REVENUE account instead of subtracting from the Bad Debts Expense. Aug. 15 Jan.20 Accts. Rec./J. Lafollette Uncollect. Accts Recovered 500

GENERAL JOURNAL DATEDESCRIPTIONPRDEBITCREDIT Bad Debts Expense Accts. Rec./J. Lafollette 500 Step #2 Record the collection. Aug. 15 Jan.20 Accts. Rec./J. Lafollette Uncollect. Accts Recovered Accts. Rec./J. Lafollette Cash 500